What is Drawdown : Types & Importance in Investing

Key Takeaways
 

• Drawdown is a measure to show risk in investment.
   
• Drawdown is not always a real loss.
   
• Investors look at drawdowns to see which funds or strategies can handle ups and downs in the market more safely.

A drawdown is the fall in value from the highest point of an investment to its lowest point before it recovers. It shows how much an investment has dropped and helps investors understand the risk involved.

For example, let’s say Priya invests ₹10,00,000 in a mutual fund. Over time, the value rises to ₹12,00,000 but then drops to ₹9,00,000 before climbing back. The drawdown here is the percentage loss from the peak of ₹12,00,000 to the trough of ₹9,00,000.

Example of Drawdown Calculation
 

This 25% drawdown highlights the investment's risk and helps Priya decide whether to continue or adjust her portfolio. Investors often use drawdowns to compare funds or track their portfolio's performance during market swings.

In this blog, we will explore why drawdowns matter, types of drawdowns, and how to limit them.

Why Understanding Drawdowns Matters in Investing?

Knowing what drawdown means helps you clearly see how risky an investment is. It illustrates the potential for your portfolio to decline in value and the time it may take to recover. This knowledge helps you make smarter choices and protect your money in uncertain times.

Here’s how understanding drawdowns can guide your investment journey:
 

For example, an investor focused on safety may prefer assets with smaller drawdowns and steady recovery. On the other hand, someone willing to accept more risk might pick investments with bigger drawdowns, hoping for higher future gains.

In the end, understanding drawdowns is not just about knowing your losses but also about managing your expectations, choosing the right investments, and staying prepared for market ups and downs.

Understanding the Ups and Downs

The Basics of Drawdowns in Investing

In investing, prices move in cycles. The highest point is called a peak, and the lowest is a trough. The fall from peak to trough is known as a drawdown.

To measure how deep and long these dips are, investors use tools like the Ulcer Index (UI). This index calculates drawdown only after the investment climbs back to its previous high. If measured too early, a larger dip could still come.

Example

If a fund rises to ₹20,000, drops to ₹16,000, and later climbs back to ₹20,000, the drawdown is recorded only after recovery.

Drawdowns are useful for tracking risk and volatility. While standard deviation shows price swings, ratios like the Sterling ratio use drawdowns to weigh risk against reward.

Bonus Tip: For short-term investors or retirees, drawdowns can offer a clearer view of potential losses during market dips.

Why Drawdowns Can Feel Risky but Aren’t Always Bad?

A drawdown is like falling into a small hole during a walk. The deeper the hole, the harder it is to climb back up. In investing, the bigger the fall in price, the more the investment needs to rise to get back to where it started.

Here’s what that looks like:
 

So, if a fund drops by 20%, it doesn’t need to just rise 20% again; it must grow by 25% to return to the top. That’s why many investors panic and sell when prices fall.

But here's the catch: selling too soon can lock in those losses. During the 2008 market crash, prices dropped fast, some days by 6% to 9%. Many people sold everything out of fear. But those who stayed saw their investments grow by 70% to 147% over five years.

So, if you don’t need the money right away, it’s often smarter to wait. The market has a history of bouncing back.

Drawdown Risk for Retirees

Why Recovery Time Matters More in Retirement?

Retirees often rely on their investments for regular income. But when the market drops sharply, there may not be enough time left to recover those losses. That’s why drawdowns are more dangerous for people in or near retirement.

To manage this risk, retirees should first decide how much of a drop they're willing to tolerate. This is called the Maximum Drawdown (MDD). Comparing the MDD with how much a fund has dropped in the past can help make safer investment choices.
 

Bonus Tip: One smart way to reduce risk is by diversifying. This means investing in different asset types like stocks, bonds, cash, and commodities. Because these don’t all move the same way at the same time, it lowers the chance of everything falling together.

Diversification helps retirees stay invested, take fewer losses, and wait patiently for recovery without risking their full income.

A Simple Example of a Drawdown

Let’s say a trader buys shares in XYZ Corp. at ₹100 each. The share price climbs to ₹110, then falls to ₹80 before rising again. In this case:

• Peak price = ₹110
• Trough price = ₹80
• Drawdown = (₹110 − ₹80) ÷ ₹110 = 27.3%

Although the drawdown is 27.3%, the trader’s actual (unrealised) loss at the lowest point is only ₹20, since they bought the stock at ₹100, not at the peak of ₹110. This shows that a drawdown is not always the same as a real loss.

Now, suppose the stock later rises to a new peak of ₹120, drops again to ₹105, and then returns to ₹120. That second dip becomes a new drawdown:

• Drawdown = (₹120 − ₹105) ÷ ₹120 = 12.5%

This example helps investors understand that drawdowns measure price movement between peaks and troughs, not just personal profit or loss.

Types of Drawdowns: Absolute vs. Maximum

When discussing drawdowns, investors often come across two common types:

• Absolute Drawdown
  This measures the drop from the original investment amount to the lowest point. For example, if you invested ₹1,00,000 and the value falls to ₹85,000, the absolute drawdown is ₹15,000.
   
• Maximum Drawdown
  This refers to the largest fall from a peak to a trough over the entire investment period. It helps investors understand the worst-case loss they might face during market volatility.

Both measures provide different insights, but maximum drawdown is especially useful for comparing funds and strategies.

How to Limit Drawdown Risk in Your Portfolio

While no investor can completely avoid drawdowns, there are ways to manage and reduce their impact:

• Diversify your investments: Spread money across different asset classes to reduce reliance on a single market.
   
• Use stop-loss orders: Set limits on trades to prevent heavy losses when prices fall.
   
• Follow asset allocation: Balance between equities, bonds, and safer instruments like fixed deposits to reduce volatility.
   
• Consider systematic withdrawals: For retirees, this ensures controlled withdrawals instead of panic selling during market dips.
   
• Stay long-term focused: Short-term drops often recover; a disciplined approach helps ride out temporary downturns.

By combining these strategies, investors can limit the damage caused by drawdowns and maintain steady growth in their portfolios.

Conclusion 

Drawdown is a simple yet powerful way to measure how much an investment falls from its highest value before recovering. It tells you how risky an asset might be and helps you prepare for market ups and downs. 

Whether you are a new investor or close to retirement, understanding drawdown helps you avoid panic, choose the right assets, and manage your money more wisely. It’s not just about losses, it's about knowing how deep the fall can be and how long it might take to bounce back.

FAQ’s

1. Is a drawdown the same as a real loss?

No, a drawdown only shows the fall from a peak to a trough. You only make a real loss if you actually sell at the lower price.

2. Can drawdowns happen more than once in an investment?

Yes, every new peak followed by a fall creates a new drawdown, so an investment can have multiple drawdowns over time.

3. Why is maximum drawdown important for investors?

It shows the worst decline an investment has faced, helping investors judge how risky it might be in tough market conditions.

4. Do drawdowns only apply to shares?

Not at all. Drawdowns can occur in mutual funds, bonds, commodities, and even entire portfolios.

5. How can drawdowns affect investor behaviour?

Large drawdowns can cause panic selling, but understanding them helps investors stay calm and focus on long-term growth.
 

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